Slide 1

Ratio AnalysisProf. Milind DalviAsst. Prof. Finance Kohinoor Business School, MumbaiObjectives:To identify aspects of a businesss performance to aid decision makingQuantitative process may need to be supplemented by qualitative factors to get a complete picture.

Examples of external users of statement analysisTrade Creditors -- Focus on the liquidity of the firm.Bondholders -- Focus on the long-term cash flow of the firm.Shareholders -- Focus on the profitability and long-term health of the firm.

Examples of internal users of statement analysisPlan -- Focus on assessing the current financial position and evaluating potential firm opportunities.Control -- Focus on return on investment for various assets and asset efficiency.Understand -- Focus on understanding how suppliers of funds analyze the firm.

Is net income of $10 million the cause of celebration for shareholders?Not if the shareholders equity is $1 billion. (Because $10 million is only 1% of $1 billion.)Yes, if the shareholders equity is $20 million. (Because $10 million is 50% of $20 million) Ratio AnalysisRatio analysis isn't just comparing different numbers from thebalance sheet, income statement and cash flow statement. It's comparing the number against previous years, other companies, the industry or even the economy in general.Ratios look at the relationships between individual values and relate them to how a company has performed in the past, and how it might perform in the future.For example,current assets alone don't tell us a whole lot, but when we divide them bycurrent liabilities we are able to determine whether the company has enough money to cover short-term debts.Where do you get the data?The first step in ratio analysis is to find the data. Company Websites -Almost every public company has a website or investor relations department. For the most current quarterly or annual report you might want to check in these places first. Walt Disney is an excellent example of a company that uses the web to get information out to shareholders and prospective investors.

Where do you get the data?Yahoo Finance - A touchstone for many individual investors, Yahoo! Finance is a great resource for financial news, and lays out ratios and performance data for individual companies.SEBI: Securities Exchange Board of India: All listed companies have to present quarterly data to SEBI. Hoovers.com - A great site for company analysis; some of the data requires a subscription.

Ratio analysisLiquidity the ability of the firm to pay its wayInvestment/shareholders information to enable decisions to be made on the extent of the risk and the earning potential of a business investmentGearing information on the relationship between the exposure of the business to loans as opposed to share capitalProfitability how effective the firm is at generating profits given sales and or its capital assetsFinancial the rate at which the company sells its stock and the efficiency with which it uses its assets

Liquidity ratiosCurrent ratioLiquid ratioCurrent RatioThe ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. Current Ratio - GoogleDec 13Dec 12Dec 11Dec 10Dec 09Current Ratio4.584.225.924.1610/62Liquid Ratio4.253.905.623.9210.07Benchmarks Current RatioFacebook Inc. 11.8810.715.125.77Yahoo Inc. 3.754.382.862.672.67Internet Sector (US.) Current Ratio4.964.645.524.017.56Technology Sector (US.) Current Ratio2.182.011.971.851.97Some other CompaniesMarch 14March 13March 12March 11March 10Hindustan Unilever Ltd. Current Ratio0.740.760.830.860.84Liquid Ratio0.440.450.460.460.45Jubilant FoodworksCurrent Ratio0.640.680.590.880.78Liquid ratio0.530.570.450.720.68Tata MotorsCurrent Ratio0.430.420.500.520.44Liquid Ratio0.360.400.430.520.44Activity ratiosStock / Inventory turnover ratioDebtors turnover ratioCreditors turnover ratio

Inventory turnover ratio:Managing inventory levels is important for most businesses and this is especially true for retailers and any company that sells physical goods. The inventory turnover ratio is a key measure for evaluating just how efficient management is at managing company inventory and generating sales from it.Inventory turnover tells how much inventory is sold over a period of time. It is calculated as:Cost of Goods Sold Average Inventory Or Sales Inventory(Average Inventory Cost of Goods Sold) x 365

Inventory turnover ratio (cont.)Usually, a higher inventory turnover ratio is preferred, as it indicates that more sales are being generated given a certain amount of inventory. Sometimes a very high inventory ratio could result in lost sales, as there is not enough inventory to meet demand. It is always important to compare the inventory turnover ratio to the industry benchmark to asses if a company is successfully managing its inventory.

Inventory turnover ratio (cont.)For the fiscal year ended Jan. 2014, Wal-Mart Stores Inc (WMT) reported annual sales of $476.3 billion, year-end inventory of $44.9 billion, and annual cost of goods sold (or cost of sales) of $358.1 billion.Its inventory turnover for the year equals: $358.1 billion $44.9 billion = 8.0Its days inventory equals:(1 8) x 365 = 46 days.This indicates that Wal-Mart sells its entire inventory within a 46-day period, which is quite impressive for such a large, global retailer.

Receivables turnover ratioBy maintainingaccounts receivable, firms are indirectly extending interest-free loans to their clients. A high ratio implies either that a company operates on acash basisor that its extension of credit and collection of accounts receivable is efficient.A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm.Debtor Days = Debtors / sales turnover x 365 ORCredit sales / average debtors365 / Receivables turnover ratio.

Creditors / Payables turnoverIndicates quality of payables and how successful the firm is in its payment.Creditor Days = Creditors / purchases turnover x 365 OR Net credit purchases / Average creditors & 365 / Creditors turnover ratio. Gives a measure of how long it takes the business to pay the debts

Inventory turnover Apple Inc.Sept 14Sept 13Sept 12Sept 11Sept 10Apple Inc. 53.1860.43111.0683.0337.62BenchmarkEMC Corp.-----6.566.727.768.16HP Co.13.2314.2914.6213.0214.86Computer Hardware Sector (US.)-----22.0622.6618.3117.03Technology Industry (US.)-----16.0815.9114.5014.12Receivables and Payable TurnoverApple Inc.Sept 14Sept 13Sept 12Sept 11Sept 10Receivables turnover10.4713.0414.3220.1611.84Payables turnover3.724.774.154.403.29Receivables TurnoverMar. 14Mar. 13Mar 12Mar. 11Mar. 10Reliance Industries34.6123.7818.4017.0523.67Infosys6.476.256.506.816.37Hindustan Unilever33.9634.1327.2724.3429.24Leverage ratiosDebt equity ratioInterest coverage ratioDebt Equity ratioA measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.Debt equity ratio = Long term debt / Shareholders equityA high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.Interest Coverage ratioTimes interest earned ratio:EBIT / Interest.It is calculated to know the payment of companys available income towards interest charges.Interest payments are more often associated with long term liabilities.

Debt Equity ratio Apple Inc.Debt Equity RatioSept 14Sept 13Sept 12Sept 11Sept 10Apple Inc. 0.320.14000000BenchmarksEMC Corp.---0.320.080.180.20HP Co.0.730.831.270.790.55Computer Hardware Sector (US.)-----0.270.180.250.24Technology Industry (US.)-----0.270.250.280.25Some other examplesMar. 14Mar 13Mar 12.Mar 11Mar 10Hindustan UnileverDebt Equity0000000000Interest Coverage --------------------------Suzlon Industries.Debt / Equity23.3933.891.481.741.92Interest Coverage- 0.43- 1.200.707.130.42Tata Steel Ltd.Debt Equity1.741.681.231.542.31Interest Coverage2.561.822.233.291.17Profitability ratiosGross Profit ratio = Gross profit / Net sales Profit Margin ratio = Net income (PAT) / Net sales Return on Assets (ROA) = Net income / Average total assetsReturn on Equity (ROE) = Net Income / Shareholders equity

Profitability ratios Apple Inc.Sept 14Sept 13Sept 12Sept 11Sept 10Gross Profit Margin38.5937.6243.8739.3835.96Operating Profit margin28.7228.6735.3031.2228.19Net Profit margin21.6121.6726.6723.9521.48ROE35.4229.9835.5033.8329.32ROA17.0417.8923.7022.2818.64Benchmarks Operating Profit MarginEMC Corp-----17.8718.2617.2115.77HP. Co.6.456.35-9.197.619.11Computer Hardware Sector Operating Profit Margin-----19.6716.1318.3611.63Technology Industry Operating Profit Margin-----23.5321.4524.1923.86Earnings per share.The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.It is calculated as: Net Income / No of shares outstanding. Diluted EPS expands on basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number.

Price Earnings ratio (P/E)P/E is short for the ratio of a company's share price to its per-share earnings. It is calculated as Market value per share / Earnings per share. Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as thetrailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as theleading or projected P/E.P/E (cont.)Theoretically, a stock's P/E tells us how much investors are willing to pay per dollar of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay $20 for every $1 of earnings that the company generates.

Book Value per share A financial measure that represents a per share assessment of the minimum value of a company's equity. More specifically, this value is determined by relating the original value of a firm's common stock adjusted for any outflow (dividends and stock buybacks) and inflow (retained earnings) modifiers to the amount of shares outstanding.It is calculated as Value of common stock + R&S / No of shares outstanding.

Du-Pont AnalysisIt is a method of performance measurement that was started by the DuPont Corporation in the 1920s. DuPont analysis tells us that ROE is affected by three things:- Operating efficiency, which is measured by profit margin- Asset use efficiency, which is measured by total asset turnover- Financial leverage, which is measured by the equity multiplierIt is calculated as: ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)Du-Pont (cont.)(ROE) is a closely watched number by knowledgeable investors. It is a strong measure of how well a company's management creates value for its shareholders. However, this value could also increase because of increase in debt which can make the stock more risky. Without breaking down ROE components, investors could be made to believe that the company is a good investment, when it is not. DuPont (cont.)To avoid mistaken assumptions, a more in-depth knowledge of ROE is needed. In the 1920s the DuPont corporation created an analysismethod that fills this need by breaking down ROE into a more complex equation. DuPont analysis shows the causes of shifts in the number.DuPont (cont.)ROE = (net profit margin) * (asset turnover) * (equity multiplier)These components include:Operating efficiency - as measured byprofit margin.Asset use efficiency - as measured bytotal asset turnover.Financial leverage - as measured by theequity multiplier.

DuPont (cont.)Three step process:Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get ROE = (net income / sales) * (sales / shareholders' equity)ROE broken into two components: the first is net profit margin, and the second is the equity turnover ratio. Now multiply (assets / assets), we end up with the three-step DuPont identity:ROE = (net income / sales) * (sales / assets) * (assets / shareholders' equity)This equation for ROE breaks it into three widely used and studied components:ROE = (net profit margin) * (asset turnover) * (equity multiplier)